Should Central Banks Burst Bubbles? Risk Sharing and the Welfare Effects of Bubble Policy

58 Pages Posted: 8 Aug 2019

See all articles by Harlan Holt

Harlan Holt

University of Mississippi; Independent

Date Written: August 6, 2019

Abstract

This paper investigates the welfare consequences of bubble policy in a greater-fool bubble model with rational, risk averse investors in an asset market. Some investors may be informed that the asset is overpriced, and try to sell to uninformed buyers. A central bank prevents speculative bubbles by revealing the state of the world to the entire market if at least one agent knows for sure that the asset is overpriced. We show that such a policy may be harmful for both buyers and sellers in asset markets, because the information revelation interferes with beneficial risk sharing between the agents, as in Hirshleifer (1971). This contrasts with previous results that show that anti-bubble policy can improve the allocation of production in asset markets. Therefore, this study suggests that asset market policy presents a trade-off between the allocation of production and the allocation of risk.

Keywords: Asset bubbles, Financial market policy, Macroeconomics

JEL Classification: D, E, G

Suggested Citation

Holt, Harlan and Holt, Harlan, Should Central Banks Burst Bubbles? Risk Sharing and the Welfare Effects of Bubble Policy (August 6, 2019). AIER Sound Money Project Working Paper No. 2019-12, Available at SSRN: https://ssrn.com/abstract=3433440 or http://dx.doi.org/10.2139/ssrn.3433440

University of Mississippi ( email )

371 Holman Hall
University, MS 38677
United States

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